Amazon: Retail's $40 Billion Slam

Summary

In this article, I decided to look at the recent developments surrounding Amazon and its decision to buy Whole Foods for $13.7 billion.

The transaction may seem odd to investors at first glance, but when you consider all that Amazon has done recently, it may actually be a great idea.

There are plenty of risks here and investors should not anticipate rapid development of Amazon's operations, but if it does things right, it could own retail in the future.

June 16th was one heck of a day for shareholders in a number of retail outlets and, especially, for shareholders in Amazon (NASDAQ:AMZN) and Whole Foods Market (WFM). After news broke that Amazon had agreed to buy Whole Foods in a multi-billion dollar deal, shares of both went up while the share prices of other players in the retail space, particularly those that have exposure to the grocery space, took a beating. In what follows, I will give my thoughts on the deal and say what I believe this seems to mean for investors in the relevant entities moving forward.

A look at the deal... and the fallout

According to a press release issued by both Amazon and Whole Foods, Amazon has agreed to buy up Whole Foods for $42 per share. This represents a roughly 27% premium over where the company's shares traded previously and values the business at approximately $13.42 billion. This excludes debt, which will bring the deal's value up to $13.7 billion. Amazon has stated that the transaction will be all cash in nature, but we will have to wait and see about whether or not the firm will take on debt to make the deal work. As of the end of its most recent fiscal quarter, Amazon's cash and cash equivalents stood at $19.33 billion and its marketable securities came out to $6.65 billion, so they technically can do this without debt, but do they want to give up valuable liquidity and the prospect of a tax shield?

As a result of this announcement, the retail industry tanked for the day. Shares of Walmart (NYSE:WMT) closed down 4.7%, but it was the least-hit of the major players. Target (NYSE:TGT) fell by 5.1% while Costco (NASDAQ:COST) dropped 7.2%. Of course, the hardest hit player for the day was Kroger (NYSE:KR), which saw its share price plummet 9.2% after having seen, in the prior trading session, its stock drop 18.9% on lackluster guidance, for a two-day decline of 26.4%. According to CNBC, companies in this space lost a total of $40 billion in market value for the day, with Walmart alone accounting for a decline of around $11.1 billion. The market perceived the news as a positive for Amazon, sending its shares higher at the close by 2.4%, while Whole Foods' stock went up 29.1% to close at $42.68 per share. This ascent beyond the agreed-upon purchase price has stoked speculation in the market that this may be the start of a bidding war for the entity.

Some major implications for Amazon and Whole Foods

If this purchase goes through, the implications for both Amazon and Whole Foods as an entity could be meaningful. For years, Whole Foods has been growing its physical presence, but the picture over the past couple of years has been mixed. While sales have continued to grow, comparable store sales for the retailer fell by 2.5% in 2016, and management has said that comparable store sales for this year could range between -2.5% and 0%.

On the bottom line, things have been even worse. Since 2014 ended, store sales have dropped, falling from $722,000 per location each week, on average, to $682,000 per location last year. This appears to have come about despite management's desire to open larger stores. As of the end of last year, the retailer operated 456 locations (436 of which are in the US), with an average square footage of 39,000. At the end of 2016, the firm had another 98 locations in development with an average square footage of 42,000, which indicates that sales per store have shrunk despite focusing, recently, on larger locations. This drop in sales per store each week may be one reason why the firm's bottom line, as shown in the graph above, has been fairly flat for the past few years. As sales per square foot decline, margins should contract, as can be seen in the table below, which shows Whole Foods' cost of goods sold over the past five years.

*Created by Author

Now, to be fair, matters have started to improve for Whole Foods to some degree. While this year is slated to be a wash or to be negative in terms of comparable store sales, the company's free cash flow (not counting growth capex) has held up quite well. In the first half of this year, the entity's free cash flow came in at $475 million, up from $434 million the same time last year. This compares to free cash flow of $795 million for all of last year and implies a price/true free cash flow ratio that Amazon is paying for the business of 16.9. That's not great, but it's also not bad.

For investors who don't follow Amazon too closely, this deal may be a head-scratcher. After all, why would an e-commerce business want to own, lock, stock, and barrel, a physical retail outlet? Simply put, it comes down to future potential. You see, there are two things about Amazon that make Whole Foods (or really any retailer) an attractive prospect, both of which can generate meaningful synergies and growth prospects for Amazon down the road.

For starters, we know that Amazon has been focused on ultra-fast delivery. Just the other day, for instance, the firm announced that it had expanded its Prime Now services to the Denver, Colorado, area by partnering up with Sprouts Farmers Market (NASDAQ:SFM). Through the deal, the company will offer free two-hour delivery of not just food products but also non-food items for members who sign up with Prime Now. In addition to this, for those who want delivery faster, a delivery charge of $7.99 can get the items to your door in one hour or less.

This isn't the first time, however, that Amazon has entered into one of these arrangements. In fact, with this deal, the firm now offers the same kind of deliveries to over 30 cities across the US. This is particularly interesting when you consider the opportunity afforded to Amazon by buying up Whole Foods. While Amazon has over 70 fulfillment centers to-date, compared to the 11 distribution centers controlled by Whole Foods (plus 3 seafood processing and distribution centers and 1 for specialty coffee), the latter has, as of today, 464 stores that can essentially be used as a launchpad for Amazon's fast delivery service. It's unclear what might become of the 365 by Whole Foods Market, the company's early-stage value item business.

*Taken from Whole Foods

What's more, as you can see in the image above, Whole Foods' locations span 42 states, plus Washington DC (they have some in Canada and the UK as well), these locations appear to be focused on high population density regions on the east coast, the west coast, and in Texas and Florida. It's worth mentioning that, of the locations Whole Foods operates, 85 are in California, 31 are in Massachusetts, and 29 are in Texas. Interestingly, only 18 of their stores are owned by them, but the high lease rate will afford Amazon some flexibility in how to operate moving forward.

Now, before you get too excited about this, you should know that Whole Foods already offers home delivery in as little as one hour, largely through its partnership with Instacart. Users who have joined Instacart pay for the company to facilitate deliveries from Whole Foods (and other locations like Target and Costco) to their homes. Given Amazon's approach to the home delivery method, it's highly probable the firm will want out of the contract, but Whole Foods is currently in year 2 of a 5-year extension. My guess is that they will end up paying Instacart a sizable fee to cancel the contract, but it is possible they could be locked in, at least in regards to perishable items.

The second thing that makes this deal appealing, in my eyes, is Amazon Go. Last year, Amazon launched an 1,800 square foot concept store in Seattle where it was testing technology that would allow, in theory, for customers to walk in, take the items they wanted off the shelf, and walk out, with their account being charged automatically. Interestingly, prior to that happening, I had been consulting one of my friends who wanted to do something a bit similar but, when we found out about Amazon's plans, we decided to put a stop to the concept. Their technology is vastly superior to what we had imagined and it would have been a bad idea to compete against such a big player without a superior value proposition.

The original plan, for Amazon, was that they were going to allow members of the public, instead of just Amazon employees, to enter the store by the early part of this year. However, that has been delayed as they have hit upon some technical difficulties, largely surrounding their technology's ability to track large numbers of customers at a time. That said, the firm does not appear interested in halting the program because, in May of this year, they put up a job posting looking for somebody who could locate areas where they could open Amazon Go locations.

By acquiring Whole Foods, Amazon's management team is likely thinking that they can use the significant footprint provided by the retailer in order to make the expansion of the Amazon Go concept a reality and do so rather quickly. Interestingly, the company has said that it has no plans, right now, to let go of the employees at Whole Foods, but it's not a stretch to imagine that, once their technology is perfected, the company will not hesitate to roll it out in order to replace human workers.

In regards to both Prime Now and Amazon Go, there's something else that might have lured Amazon into buying Whole Foods. Not only is Whole Foods a truly tech-savvy enterprise (it boasts about its 13 million + social media followers and its high-quality data analytics that has allowed it to estimate that its stores receive 8 million weekly customer visits while having 30 million unique customers), it is considered a quality provider of groceries and other items. Of its roughly 30,000 SKUs (shelf keeping units), around 5,300 of them (plus another 400 that are short-term in nature) are exclusive to its stores. Collectively, these account for about $2.3 billion (or 15%) of the company's sales. Exclusive items, if they are popular, can demand higher prices and drive traffic. By having these for itself, Amazon could make its Prime Now and Amazon Go concepts that much more appealing.

What does this mean for Walmart?

The first question I asked, while reviewing this deal, is what does this mean for Walmart? As the largest retailer out there, it has some strong advantages that even Amazon can't compete with (for now), but there's a reason why it lost nearly $11.1 billion in market value in response to this transaction. You see, there's a very high chance, in my opinion, that both Prime Now and Amazon Go (or services similar to these) will dominate the retail world in the future. Having goods delivered and, when you do go to the store, being able to avoid the long lines that have become synonymous with Walmart, happens to be quite appealing, especially to younger people like me (I'm 28).

Walmart has recognized this and has made its own moves to capture a foothold in this market. Last year, the firm acquired Jet.com for $3.3 billion ($3 billion in cash and $300 million in shares). The site is a leading e-commerce business that showed tremendous progress and, in Walmart's opinion, gave the retailer a more significant hold on online sales. Through their Walmart website, they offer free 2 day shipping on over 2 million items, and offer discounts for customers willing to come inside the store to pick up their goods. The company has also moved in the direction of providing food delivery through its Jet Fresh program, which allows customers to receive fresh groceries in 1 to 2 days. Today, this program is capable of reaching half of the US population. On the same day as Amazon announced its Whole Foods purchase, Walmart expanded its online presence by acquiring, for $310 million in cash, Bonobos, which is a leading online apparel brand. This did not receive much of any attention from the market.

This leads us to the largest advantage Walmart has, but also gives us a glimpse into how they are likely botching their potential. You see, according to the company, through its roughly 4,700 US locations (so more than 10 times larger than Whole Foods in the US), its operations are within 10 miles of 90% of the US population. Even if Amazon is successful, it could take decades to have that kind of presence and, normally, I would be wary of the firm taking on such an established competitor. However, Walmart has not shown any signs of approaching the picture in a high-tech way like Amazon has.

Besides acquiring e-commerce sites and offering different delivery options to customers, the only meaningful development that I could find from Walmart recently that would be comparable, at least in part, to the potential Amazon is trying to unlock is its pilot program (2 locations in New Jersey and 1 in Arkansas) where it is paying its employees to deliver goods to customers on their way home from work. This is, usually, next-day delivery, which is still worse than what Amazon is striving for.

The lack of high-tech options and ultra-fast delivery makes me wonder who owns the future of retail. It is far, far too early to proclaim Amazon the winner because its technology is still flawed and any sort of rollout will take years, most likely. That said, Walmart, the largest player in this space by a large margin, is so far behind where Amazon is planning to be that I would be surprised to see it be able to match the e-commerce giant in the long run.

Takeaway

Based on the data provided, it's clear why Amazon is acquiring Whole Foods. The entity, while not being that cheap of a purchase (but not too expensive either), is a quality provider of products. What's more is that, if Amazon continues in the direction that they appear to be going, this could provide a fascinating launchpad for the company's Prime Now and Amazon Go services. If the firm can pull this off, it could, very well, own the future of all retail.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.